Index funds are funds that are managed according to a formula. In this regard they are considered “passively managed” because they are not managed according to the skill or intuition of the manager. Instead, a formula is applied to determine what securities will be included in the fund, and a similar formula is used to identify the proportion of each security to be included in the fund.
Some index funds are capitalization-weighted. In such a fund, stocks meeting a criteria (e.g. “common stock of 100 companies publicly traded on one of the major exchanges with the largest market capitalization”) are selected for inclusion in the fund. The proportion of securities of a given company that will be included in the index (e.g. the weight of the company) may be determined at least in part using a formula that includes the market capitalization of each of the included securities or each company corresponding to the security. For example, the proportion may be by identified by summing the total value of all of the common stocks of each included company to identify a sum, and dividing the market value of the common stock of a particular company by the identified sum to identify the ratio of that company's common stock that will be included in the index fund. The calculation process is performed for every security in the fund. The amount of each security is its proportion multiplied by the dollar value invested in the fund.
Other variations may be used. For example, rather than using market capitalization alone, several factors may be used to determine which securities will be included, as well as their respective proportions in the fund.
Capitalization-weighted funds are inexpensive to manage. The fund may be rebalanced at certain times of the year or at other times to comply with the formulas used to determine the proportion of securities. The rebalancing process adjusts the proportions based on a recent computation using the formula in the same manner described above. In addition, the rules of inclusion are used to determine whether securities should be added or removed from the fund, either at the same time as the fund is rebalanced, or at different times. Because both of these are performed according to a formula, they can be managed by administrators rather than high paid stock pickers, without expensive research.
However, capitalization-weighted funds suffer when speculative run-ups of a security cause it to be purchased in a higher proportion than would be desirable. During periods in which a stock falls out of favor, it will be purchased in lower proportion than might be desirable based on fundamentals alone. Thus, capitalization-weighted funds may provide sub-optimal returns.
Index funds have been proposed that do not use market capitalization as a factor, or as the only factor, in either the determination of which securities are included, the formula used to determine the proportion of securities relative to others in the fund, or both. Such non-capitalization-weighted funds avoid the drawbacks of capitalization-weighted index funds, but the factors thus far proposed may still not maximize investor returns.
What is needed is a system and method that uses a weight other than capitalization that can improve investor returns.